If your business is a partnership, including a limited liability company taxed as a partnership, it’s critical to consider the potential impact of centralized audit rules that are now in force. There are steps you can take before an IRS audit to minimize the burden, including opting out of the new rules (if eligible), amending your partnership agreement and appointing an appropriate “partnership representative.”
Getting the Gist
The new centralized audit rules are complex, but it’s important for partnerships to understand their gist so they can be prepared in the event of an audit. The biggest change allows the IRS to determine tax adjustments — and assess additional taxes, penalties and interest — at the partnership level. This is a significant departure from the tax agency’s previous approach: generally assessing and collecting taxes at the individual partner level.
The new rules have consequences. First, they give the IRS authority to assess and collect taxes from a partnership on “imputed underpayments” in the tax year being audited (the “reviewed year”) at the highest marginal tax rate. That can be done without considering partner-level circumstances or tax attributes that might reduce partners’ tax liabilities.
Second, because a partnership takes imputed underpayments into account in the adjustment year — that is, the year in which the audit is completed — the new rules can lead to inequitable results for the partnership’s current partners. These partners are potentially liable for tax under-payments that benefited reviewed-year partners who’ve since left the partnership.
To avoid these results, a partnership may obtain a modification of an imputed underpayment by showing that a lower tax rate is appropriate. Or it can ask the responsible partners to file amended returns and pay the additional tax. Alternatively, partnerships can file an election to “push out” adjustments to the reviewed-year partners.
Choosing a Representative
The new rules discard the “tax matters partner” in favor of a powerful “partnership representative” who must be designated on the partnership’s tax return each year. The representative has “sole authority to act on behalf of the partnership” in its dealings with the IRS.
Gone are the days when individual partners had the right to participate in an audit. Considering the partnership representative’s vast authority, it’s critical to choose yours carefully. Keep in mind that the representative needn’t be a partner. Any individual with a substantial U.S. presence can serve, as well as an entity (even the partnership itself) that designates an individual to act on its behalf.
Minimizing the Impact
There are several steps you can take before an audit to minimize the impact of the new rules:
Opt out, if eligible. Partnerships can opt out of the new audit rules if they file 100 or fewer Schedule K-1s (including K-1s filed by any S corporation partners) and all their partners are either individuals, S corporations, C corporations (including foreign entities that would be treated as C corporations if they were organized in the U.S.) and estates of deceased partners. (See “How to Opt Out” below.)
Amend your partnership agreement. If you can’t opt out, consider amending your partnership agreement to streamline the centralized audit process. Useful provisions include 1) requiring current and former partners to provide tax information or file amended returns if necessary, 2) requiring the partnership to make a pushout election, and 3) indemnifying current partners against tax liabilities attributable to former partners.
Establish procedures for selecting and removing partnership representatives. It’s also a good idea to outline the representative’s duties and responsibilities and to place appropriate limits on his or her (or its) authority. For example, you might prohibit the representative from taking certain actions without the approval of a majority of the partners.
About this last step, you may recall that, as far as the IRS is concerned, the partnership representative has sole authority to act on the partnership’s behalf. But that doesn’t mean you can’t set forth contractual rules governing the relationship between the representative and the partnership.
Weighing the Costs
Partnerships should familiarize themselves with the new audit rules and assess the rules’ potential tax impact on the partnership and its partners. Those eligible to opt out should consider doing so. Others should ponder strategies for managing the audit process, such as amending their partnership agreements and appointing the right partnership representative. Contact us with any questions you might have about the new audit rules and if you should opt out.
How to Opt Out of Centralized Audit Rules
If your partnership is eligible to opt out of the centralized audit rules, here’s the procedure for making that election:
- Check the designated box on a timely filed (including extensions) Form 1065 Schedule B.
- Complete and attach to your return Form 1065 Schedule B-2, which includes, among other things, each partner’s name, tax identification number and federal tax classification, along with an affirmative statement that all partners are eligible.
- Notify all partners of the election within 30 days after it’s made.
If the IRS deems the election invalid, it’ll notify you in writing and the centralized audit rules will apply to your partnership. Once a valid election is made, it can’t be revoked without IRS consent.